Generating historically-based stress scenarios using parsimonious factorization

Generating historically-based stress scenarios using parsimonious factorization Purpose– This paper aims to describe a robust empirical approach to generating plausible historically based interest rate shocks, which can be applied to any market environment. These interest rate shocks can be readily linked to movements in other key risk factors, and used to measure market risk on institutions with large fixed-income portfolios. Design/methodology/approach– Using yield curve factorization, we parameterize a time series of historical yield curves and measure interest rate shocks as the historical change in each of the model’s factors. We then demonstrate how to add these parameterized shocks to any market environment, while retaining positive rates and plausible credit spreads. Given a set of shocked interest rate curves, joint risk factor movements are calculated based upon historical, reduced form dependencies. Findings– Our approach is based upon yield curve parameterization and requires a parsimonious yet flexible factorization model. In the process of selecting a model, we evaluate three variants of the Nelson–Siegel approach to yield curve approximation and find that, in the current low interest rate environment, a 5-factor parameterization developed by Björk and Christensen (1999) is best suited for accurately translating historical interest rate movements into plausible, current period shocks. Originality/value– An accurate measure of market risk can help to inform institutions about the amount of capital needed to withstand a series of adverse market events. A plausible set of shocks is required to ensure market value, and cash flow projections are indicative of meaningful market sensitivities. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Risk Finance Emerald Publishing

Generating historically-based stress scenarios using parsimonious factorization

The Journal of Risk Finance, Volume 15 (5): 21 – Nov 21, 2014

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Publisher
Emerald Publishing
Copyright
Copyright © Emerald Group Publishing Limited
ISSN
1526-5943
DOI
10.1108/JRF-03-2014-0036
Publisher site
See Article on Publisher Site

Abstract

Purpose– This paper aims to describe a robust empirical approach to generating plausible historically based interest rate shocks, which can be applied to any market environment. These interest rate shocks can be readily linked to movements in other key risk factors, and used to measure market risk on institutions with large fixed-income portfolios. Design/methodology/approach– Using yield curve factorization, we parameterize a time series of historical yield curves and measure interest rate shocks as the historical change in each of the model’s factors. We then demonstrate how to add these parameterized shocks to any market environment, while retaining positive rates and plausible credit spreads. Given a set of shocked interest rate curves, joint risk factor movements are calculated based upon historical, reduced form dependencies. Findings– Our approach is based upon yield curve parameterization and requires a parsimonious yet flexible factorization model. In the process of selecting a model, we evaluate three variants of the Nelson–Siegel approach to yield curve approximation and find that, in the current low interest rate environment, a 5-factor parameterization developed by Björk and Christensen (1999) is best suited for accurately translating historical interest rate movements into plausible, current period shocks. Originality/value– An accurate measure of market risk can help to inform institutions about the amount of capital needed to withstand a series of adverse market events. A plausible set of shocks is required to ensure market value, and cash flow projections are indicative of meaningful market sensitivities.

Journal

The Journal of Risk FinanceEmerald Publishing

Published: Nov 21, 2014

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